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Taxes and Efficiency

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Why Is Tax-Efficient Investing Important?

The Schwab Center for Financial Research evaluated the long-term impact of taxes and other expenses on investment returns, and while investment selection and asset allocation are the most important factors that affect returns, the study found that minimizing taxes also has a significant effect.1

There are two reasons for this. One is that you lose the money you pay in taxes. The other is that you lose the growth that money could have generated if it were still invested. Your after-tax returns matter more than your pre-tax returns. It’s those after-tax dollars, after all, that you’ll be spending now and in retirement. If you want to maximize your returns and keep more of your money, tax-efficient investing is a must.

Tax-Efficient Investments

Most investors know that if you sell an investment, you might owe taxes on any gains. But you could also be on the hook if your investment distributes its earnings as capital gains or dividends; whether you sell the investment or not.

By nature, some investments are more tax-efficient than others. Among stock funds, for example, tax-managed funds and exchange traded funds (ETFs) tend to be more tax-efficient because they trigger fewer capital gains. Actively managed funds, on the other hand, tend to buy and sell securities more often, so they have the potential to generate more capital gains distributions (and more taxes for you).

Bonds are another example. Municipal bonds are very tax-efficient because the interest income isn’t taxable at the federal level—and it’s often tax-exempt at the state and local level, too (munis are sometimes called « triple free » because of this). These bonds are good candidates for taxable accounts because they’re already tax efficient.

Treasury bonds and Series I bonds (savings bonds) are also tax-efficient because they’re exempt from state and local income taxes. But corporate bonds don’t have any tax-free provisions, and, as such, are better off in tax-advantaged accounts.

Tax Efficiency.

Tax efficiency minimizes the cost of complying with the tax code by reducing its administrative burden and by minimizing any distortions in the economy caused by the tax. Reducing the administrative burden not only benefits the taxpayers but also the economy since tax collection is not an objective of tax policy, but simply a requirement. Although tax accountants and lawyers help people to comply with the tax code and reduce their taxes, their work has no true economic worth since the need for their help could be eliminated by simplifying the tax code and facilitating the filing of taxes, especially through electronic filing.

Besides trying to promote or limit certain activities, much of the complexity of the tax code results from Congress giving preferential treatment to particular groups, especially the wealthy and businesses. This preferential treatment is provided not only in the way that the tax is structured, but also in the form of tax loopholes, which allows taxpayers to take advantage of weaknesses in how the laws are actually worded to circumvent them, thus lowering their taxes in a way that Congress may or may not have intended.

Loopholes exist partly because of the complexity of the tax code, but, often, they are inserted intentionally so that the wealthy can take advantage of them. For instance, there are many obvious loopholes in the taxing of gratuitous transfers that the wealthy take advantage of year after year. Indeed, a large body of law has developed allowing the wealthy to transfer their wealth at a far lower tax rate than what is assessed on working income — usually, they can transfer their entire wealth tax-free.

Another objective of tax policy that is little heeded is that deadweight losses should be minimized. Although the cost of complying with the tax code does generate some deadweight losses, most deadweight losses are incurred by the tax itself, especially when it is assessed on working income.

Another often stated objective of tax policy is that taxes should not distort economic decisions, which occurs when people decide to do something differently because of the tax. For instance, high taxes on working income discourages work because it raises the price of labor for employers and decreases the disposable income for workers. That higher prices reduces demand and lower prices decreases supply are well-established economic principles, yet working income is taxed more than investment income or gratuitous transfers. There is no economic distortion from taxes on gratuitous transfers, because everyone dies eventually, regardless of any tax. Furthermore, there is no deadweight loss from gratuitous transfer taxes. As economists like to say, the supply of death is totally inelastic, while the demand for gratuitous transfers is totally elastic, because the beneficiaries receive their gift freely. Nonetheless, preferential treatment is given to gratuitous transfers because it benefits the wealthy.

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